Taming market volatility through diversification
Understanding the factors behind diversifying your portfolio
One of the proven ways to reach your long-term financial goals is through an investment technique known as diversification. Diversification basically means spreading out your invested money across different investments types, industries, countries, etc., which can smooth out the performance of your portfolio and may lead to stronger returns over the long term. Helping you take advantage of the benefits of diversification is a central part of your advisor’s role.
One of the guiding factors behind diversification is that not all investment categories perform well at the same time; as some are increasing in value, others may be decreasing. The movement up and down of investment categories is referred to as market volatility.
Maintaining a well-balanced portfolio
A professional financial advisor will help you maximize returns and reduce the risks associated with market volatility by creating a portfolio that effectively diversifies your investments. Essentially, your portfolio represents a collection of different investments that work in harmony to help you reach your goals.
One way you can achieve portfolio diversification is to divide your investments among the major asset classes – namely, equities, fixed income and cash.
Asset classes – A range of risks and rewards
Each asset class comes with varying degrees of risk and return characteristics, and typically perform differently in certain market environments. Here’s a quick summary of each.
- Equities (e.g., stocks)
Equities refer to buying stocks or shares of a business, making you a part owner. This means you are entitled to profits when stock values increase, but are also subject to the risks of declining stock value if companies underperform.
- Fixed income (e.g., bonds, Treasury bills)
Fixed income investors lend capital in exchange for interest. Considered as creditors, bondholders often have a priority claim in case of company bankruptcy or default, making the investments less risky. Fixed income typically provides income at regular intervals.
- Cash (e.g., money market funds, bank accounts)
Cash investments provide low returns versus other asset classes, in the form of interest payments. These investments typically come with very low levels of risk.
Investment funds – One-stop diversification
Your advisor can also help achieve diversification through the use of investment funds; namely, mutual funds and exchange-traded funds (ETFs). These investment vehicles represent convenient and affordable ways to access a wide range of investments.
- Mutual funds– These are made up of a pool of assets from many investors and managed by a portfolio manager who actively seeks to produce greater returns than a specific market benchmark, such as the S&P 500 Index. With the large scale of a mutual fund, you benefit from professional management and can get strong diversification by gaining access to investments that would normally be inaccessible or too expensive for most individuals.
- ETFs– These are funds that track and seek to replicate the performance of select market indexes. Because ETFs represent a basket of securities based on the underlying index, you can gain broad diversification across entire markets, industries, regions or asset classes. ETFs are known to incur fewer administrative costs (and therefore charge lower fees to investors) since they’re simply tracking an index without trying to outperform it.